Financial Services Alert - May 20, 2014

The SEC’s Office of Municipal Securities has updated its frequently asked questions (the “FAQs”) that present its views regarding various aspects of the SEC’s municipal advisor registration rules (the “Final Rules”).   (See the Municipal Advisor topic on the Goodwin Procter Dodd-Frank Minisite for additional information on the Final Rules, the FAQs as issued in January 2014, the application of the Final Rules to banks and trust companies, and other developments affecting municipal advisors.)

The updated FAQs provide answers to questions across several categories.  Among other things, the staff provides helpful guidance regarding the definition of “proceeds of municipal securities.”  The updated FAQs set forth the staff’s view that if a municipal entity issues pension obligation bonds and contributes the proceeds to a municipal entity’s public pension fund where the proceeds are commingled with other funds, those proceeds will cease to be considered “proceeds of municipal securities” under the Final Rules.  However, if the municipal entity segregates the proceeds and continues to account for them separately, or retains control over the ability to use such proceeds for any purpose other than the exclusive benefit of pension beneficiaries, such proceeds would continue to constitute proceeds of municipal securities under the Final Rules until they are used to pay pension fund beneficiaries or to carry out other authorized purposes of the bonds.

The FAQs provide transitional guidance and relief for market participants with respect to the due diligence that they must perform on client accounts in existence prior to the July 1, 2014 compliance date of the Final Rules.  Such transitional guidance includes the staff’s suggestion that, under certain circumstances, it would be reasonable for a market participant to conclude that an account does not include proceeds of municipal securities if the market participant requests that a client provide confirmation regarding its account and does not receive a response from the client.  Market participants should document the steps undertaken in making determinations with respect to each account.  The FAQs note that, for new investments after July 1, 2014, market participants should develop policies and procedures consistent with the Final Rules and the SEC’s related guidance to determine whether such investments involve proceeds of municipal securities.  The Final Rules and guidance generally provide that in determining whether or not funds constitute proceeds of municipal securities, a person may rely on representations in writing made by a knowledgeable official of a municipal entity or obligated person regarding the nature of such investments, provided that the person seeking to rely on such representations has a reasonable basis for such reliance.

The FRB issued a notice of proposed rulemaking (the “Proposed Rule”) that would implement section 622 (“section 622”) of the Dodd-Frank Act, which established a financial sector concentration limit (the “Concentration Limit”) “that generally prohibits a financial company from merging or consolidating with, or acquiring, another company if the resulting company’s liabilities upon consummation would exceed 10 percent of the aggregate liabilities of all financial companies…”  The Proposed Rule would be designated “Regulation XX” of the FRB.  The Concentration Limit supplements the nationwide deposit cap of 10 percent of total deposits at U.S. insured depository institutions imposed by current Federal banking law.  Unlike the deposit cap, the Concentration Limit takes into account nondeposit liabilities and off-balance sheet exposures.  The Concentration Limit does not constrain organic growth by a financial company, i.e., internal growth that does not involve an acquisition or merger.

Under the Proposed Rule, exemptions from the Concentration Limit are provided for liabilities acquired in connection with: (1) the acquisition of a failing bank; (2) (with the prior written consent of the FRB) a de minimis transaction that increases liabilities by less than $2 billion; and (3) ordinary business transactions that may increase total liabilities of the financial company, e.g., acquiring shares in the ordinary course of collecting a bad debt, in a fiduciary capacity or as part of merchant or investment banking activities.

The FRB estimated that the financial sector’s current aggregate liabilities are approximately $18 trillion, leading to a current Concentration Limit of approximately $1.8 trillion.  As pointed out in the financial press, because of other Dodd-Frank Act provisions that focus on addressing matters and transactions that could pose systemic risk, bank regulatory agencies may well deny applications seeking approvals of mergers and acquisitions where the resulting organization would have aggregate liabilities of significantly less than $1.8 trillion.

Section 622 and the Proposed Rule define a “financial company” as a U.S. insured depository institution, a bank holding company, or savings and loan holding company, a foreign banking organization that is treated as a bank holding company for purposes of the Bank Holding Company Act, any company that controls an insured depository institution and a nonbank financial company that is designated by the Financial Stability Oversight Council (FSOC) for supervision by the FRB.

The Proposed Rule generally defines the liabilities of a financial institution as the “difference between its risk-weighted assets, adjusted to reflect exposures deducted from regulatory capital, and its total regulatory capital.”  Those financial companies that are not subject to consolidated, risk-based capital rules would, under the Proposed Rule, use generally accepted accounting standards.  In the FRB’s proposal, a financial company’s aggregate liabilities would be disclosed annually, but would be calculated as a two-year average.

Comments on the Proposed Rule are due to the FRB by July 8, 2014.  In the Proposed Rule, the FRB poses 14 specific questions as to which it is seeking comments, but it invites comments on all aspects of the Proposed Rule.

The New York Department of Financial Services (the “NYDFS”) plans to include cyber security as part of its bank examination process.  The NYDFS issued a report (the “Report“) entitled “Report on Cyber Security in the Banking Sector”, in which the NYDFS stated that it plans to review a bank’s cyber security incident response and event management, access controls, network security, vendor management, and disaster recover in evaluating the bank’s overall safety and soundness.  The NYDFS pointed out that while national news reports about the data breach at Target and the Bitcoin hacking scandal at Mt. Gox have recently brought more public awareness of cyber threats, the bank regulatory agencies have been warning banks for more than a year as cyber attacks have become increasingly more sophisticated.

The Report is based on a survey of 154 banks and credit unions in New York.  The survey covered industry trends, concerns, and opportunities for improvement across a cross-section of depository institutions. According to the Report, the NYDFS believes that smaller institutions are less prepared than the larger banks to handle cyber threats.

Enhancing cyber security is expected to increase the cost of regulatory compliance, especially for smaller institutions.  Steps to improve cyber security may include hiring IT security personnel, engaging outside consultants, upgrading software, and implementing new security protocols. Nevertheless, many banks recognize the importance of the investment and are already strengthening their institution’s cyber security.  Moreover, the NYDFS does not plan to have a one-size-fits-all solution.  The revised procedures are expected to be tailored to the respective bank’s risk profile.

Goodwin Procter’s Private Investment Funds, Hedge Funds, Real Estate Investment Management & Joint Ventures, and Private Equity practices issued a client alert that reviews concerns cited by the head of the SEC’s examination program in a recent speech discussing findings from inspections of newly registered private equity fund managers.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) announced a streamlined approach for requesting relief from the commodity pool operator (“CPO”) registration requirement for a CPO that delegates investment management authority as a CPO of a commodity pool (the “Delegating CPO”) to another person who is registered as a CPO (the “Designated CPO”) where the Delegating CPO does not solicit participants for the pool or manage its property.  The streamlined approach does not provide blanket registration relief, but simply specifies procedures for requesting no-action relief when certain specified criteria are met.

Past Relief for Delegating CPOs.  The criteria for using the streamlined approach are designed to be consistent with the conditions for relief from the CPO registration requirement provided to Delegating CPOs in the past as discussed in the Division’s announcement.  For example, the letter notes that the CFTC has a relatively long history of issuing CPO registration no-action relief with respect to commodity pools organized as limited partnerships with two or more general partners, such that only one general partner was required to register as a CPO.  More recently, the CFTC has provided relief in the case of commodity pools organized as limited partnerships or limited liability companies in which an affiliated investment manager was allowed to serve as the registered CPO in place of the pool’s general partner or managing member.  The CFTC has also issued no-action relief to members of a board of directors or other governing body of a commodity pool domiciled and located outside the United States.

Streamlined Approach – Criteria.  The streamlined approach is available to those that meet certain specified criteria, which include the following, among others:  (1) the Delegating CPO must have delegated to the Designated CPO all of its investment management authority with respect to the commodity pool; (2) the Delegating CPO must not participate in the solicitation of participants for the commodity pool and must not manage any property of the commodity pool; (3) the Designated CPO must be a registered CPO; (4) the Delegating CPO must not be subject to specified grounds for disqualification from registration under the Commodity Exchange Act; (5) if the Delegating CPO and the Designated CPO are each a non-natural persons, they must be affiliates; and (6) if the Delegating CPO is a non-natural person, it and the Designated CPO must have executed a legally binding document whereby each undertakes to be jointly and severally liable for any violation of the Commodity Exchange Act and the CFTC’s regulations by the other in connection with the operation of the commodity pool.

Standardized Form of Request.  To request relief using the streamlined approach, the Delegating CPO must submit a request for relief in the form provided in the attachment to the Division’s letter announcing the streamlined approach.

Other Requests for Relief.  The letter notes that the Division will continue to evaluate requests for CPO registration no-action relief whose facts do not permit use of the streamlined approach.